Unemployment risk, liquidity traps and monetary policy

Staff working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 14 May 2021

Staff Working Paper No. 920

By Dario Bonciani and Joonseok Oh

When the economy is in a liquidity trap and households have a precautionary motive to save against unemployment risk, adverse demand shocks cause severe deflationary spirals and output contractions. In this context, we study the implications of optimal monetary policy, which consists of keeping the nominal rate at zero longer than implied by current macroeconomic conditions. Under such policy and incomplete markets, expected improvements in labour market conditions mitigate the rise in unemployment risk and decline in demand. As a result, market incompleteness may alleviate contractions in output and inflation during a liquidity trap. However, reducing market incompleteness mitigates the fall in demand under realistic monetary policy rules.

Unemployment risk, liquidity traps and monetary policy

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